January 7, 2018
What is a Margin? A Margin is essentially the difference between a product’s selling price and the cost of production.
A margin is a collateral that the holder of a position in securities, options, or future contracts has to deposit to cover the credit risk of his counterparty (most often his broker). This risk can arise if the holder has done any of the following:
Margin buying is buying securities with cash borrowed from a broker, using other securities as collateral. This has the effect of magnifying any profit or loss made on the securities. The securities serve as collateral for the loan. The net value, i.e., the difference between the value of the securities and the loan, is initially equal to the amount of one’s own cash used. This difference has to stay above a minimum margin requirement, the purpose of which is to protect the broker against a fall in the value of the securities to the point that the investor can no longer cover the loan. In the 1920s, margin requirements were loose. In other words, brokers required investors to put in very little of their own money. Whereas today, the Federal Reserve’s margin requirement limits debt to 50 percent, during the 1920s leverage rates of up to 90 percent debt were not uncommon. When the stock market started to contract, many individuals received margin calls. They had to deliver more money to their brokers or their shares would be sold. Since many individuals did not have the equity to cover their margin positions, their shares were sold, causing further market declines and further margin calls. This was one of the major contributing factors which led to the Stock Market Crash of 1929, which in turn contributed to the Great Depression, a troubling financial time in the 1930s.
Illustration: Assume that the initial margin required to buy or sell a particular commodity contract is $1,000 and the maintenance margin requirement is $750. Should losses on open positions reduce the funds in your trading account to $700, you would receive a margin call for the $300 needed to restore your account back to the initial $1,000. If there were not excess funds in the account in order to bring the initial amount back up to $1,000, that position would create a margin call, a situation in which the account would need to be either immediately met with additional funds or the position liquidated to cover the margin call.
Types of margin requirements:
Current liquidating margin:
The current liquidating margin is the value of a securities position if the position were liquidated now. In other words, if the holder has a short position, this is the money needed to buy back; if he is long, it is the money he can raise by selling it.
The variation margin or maintenance margin is not collateral, but a daily offsetting of profits and losses. Futures are marked-to-market every day, so the current price is compared to the previous day’s price. The profit or loss on the day of a position is then paid to or debited from the holder by the futures exchange. This is possible, because the exchange is the central counterparty to all contracts, and the number of long contracts equals the number of short contracts. Certain other exchange traded derivatives, such as options on futures contracts, are marked-to-market in the same way.
The seller of an option has the obligation to deliver the underlying of the option if it is exercised. To ensure he can fulfill this obligation, he has to deposit collateral. This premium margin is equal to the premium that he would need to pay to buy back the option and close out his position.
Additional margin is intended to cover a potential fall in the value of the position on the following trading day. This is calculated as the potential loss in a worst-case scenario.
When the margin posted in the margin account is below the minimum margin requirement, the broker or exchange issues a margin call. The investor now either has to increase the margin that they have deposited, or they can close out their position. They can do this by selling the securities, options or futures if they are long and by buying them back if they are short. If they don’t do any of this the broker can sell his securities to meet the margin call.
Return on margin:
Return on margin (ROM) is often used to judge performance because it represents the net gain or net loss compared to the exchange’s perceived risk as reflected in required margin. ROM may be calculated (realized return) / (initial margin). The annualized ROM is equal to (ROM + 1)^(1/trade_duration) – 1
For example, if a trader earns 10% on margin in two months, that would be about 77% annualized (ROM +1)^(1/(2/12)) – 1, thus Annualized ROM = 1.1^6 – 1 = 77%
To guarantee your success at passing the FRM exam at one go, follow the link to FRM Concept Checkers for many more concepts!